Playing the Probabilities

(May 7, 2006)

Dear Subscribers and Readers,

As I mentioned in our mid-week commentary, this weekend commentary will be somewhat abbreviated, given that this author will need to take an actuarial exam this Friday.  Our upcoming Thursday morning commentary will be “taken care” of our monthly guest commentator Bill Rempel – who has been making many valuable contributions in the past (including his correct call over the last few months claiming that this bull market isn't over yet).

Going forward, we would (and we hope our subscribers would) like to focus more on specific stocks and industries (since that is where the “big money” is made) – although we would definitely continue our macro economic and stock market analysis at least once a week.  Again, any suggestions or thoughts are always welcome.

We switched from a 25% short position to a neutral position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 – giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday, January 18th at DJIA 10,840.  We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon, January 19th at DJIA 10,900 – thus giving us an average entry of DJIA 10,870.  As of the close on Friday (11,577.74), this position is 607.74 points in the red.  We then added a further 25% short position the afternoon of February 27th at a DJIA print of 11,124 – thus bring our total short position in our DJIA Timing System at 75%.  We subsequently decided to exit this last 25% short position on the morning of March 10th at a DJIA print of 11,035 – giving us a gain of 89 points.  We subsequently entered an additional 25% short position in our DJIA Timing System on Monday morning (March 20th) at a DJIA print of 11,275.  We had been trying to get rid of this latest 25% short position about a month ago.  We had opted to wait for a more oversold condition before covering it – but it was not to be, as the Dow Industrials rallied a whopping 194.99 points two Tuesdays ago (partly because of the March 28th Fed minutes released in the early afternoon) and are now up approximately 500 points since that interim low.  Again, we are now 75% short in our DJIA Timing System.

Last week, I mentioned that: “Should the market continue to rally or hold on to its current gains going into the Fed meeting, there is a strong likelihood that the market will sell off right after the Fed meeting – contrary to what many analysts and retail investors are currently expecting.  In that case, there is a good chance that we will go 100% short in our DJIA Timing System.”  Even though the market had continued to remain overbought going into the action of last week, the rally has continued – and probability now suggests that the market will sell off most probably after the Fed meeting.  Again, we will let our readers know on a real-time basis once we have decided to make changes to our positions in our DJIA Timing System.  We will email you as well as post a message on our discussion forum (for folks who have set filters in their email software) letting you know (our message on our discussion forum will be titled: “A Change in our DJIA Timing System”).

Some of our subscribers must now be thinking: “Has Henry gone crazy?”  Well, I have been known to do some crazy things sometimes – but doing “crazy things” will definitely not pay off in the stock market over the long-run.  As the title of this commentary suggests, this author is just playing the probabilities here.  Given the current overbought condition of the stock market (as suggested by the percentage of stocks over their 20-day EMAs, the percentage deviations of the Dow Industrials and the Dow Transports from their 50-day and 200-day moving averages, the VIX, and so forth), given the many divergences, and tightening liquidity, there is a strong likelihood that we will experience a correction over the next few weeks.  Therefore – at this point – we will have no hesitation going 100% short in our DJIA Timing System right before the results of the May 10th Fed meeting.  We will then re-evaluate after the Fed meeting.  Should there be a substantial improvement in breadth and liquidity (which is not very likely), we will then cover some or all of our short positions in our DJIA Timing System.

Let's now review a few things – starting with the U.S. bond market.  This is the one market we have been right on over the last few months, so we're definitely happier to discuss this!  Since our last discussion on the long bond on our April 13, 2006 commentary (“The Long Bond Secular Bull Market is Over”), the yield of the 30-year and the 10-year long bond have risen further from 5.05% to 5.20%, and 4.98% to 5.11%, respectively.  Sure, the bond markets are very oversold, but the trend still remains down at this point.

Not coincidentally, the underperformance of both the U.S. and European government bond markets has occurred in the midst of a severe underperformance of the Japanese government bond market as the Bank of Japan ends its “quantitative easing” policy which began in March 2001.  As I have mentioned before, this QE policy had the result of not only compressing bond yields in Japan, but all across the developed world as well.  As a matter of fact, the month-to-month action of the Japanese and the U.S. bond markets has had a correlation of nearly 70% since March 2001 (please see the following chart comparing the yield of the 10-year Japanese and the U.S. Treasury from January 1999 to April 2006):

As of Friday at the close, the yield of the 10-year JGB hit 1.93%.  Given that the Bank of Japan has still yet to fully end its QE policy (the target date is for the QE policy to fully end by the end of this month), there is virtually no question that government bond yields around the world should continue to rise at least until the end of this month.

The threat of a continuing rise in interest rates should serve to put a lid on the major market indices going forward – especially given that the Fed is scheduled to raise another 25 basis points in the Fed Funds rate on May 10th (at some point, the option of getting 5% on a savings account far outweighs getting a 1.7% dividend yield in the S&P 500 or even a 3.5% dividend yield on the Dow Utilities and holding these indices for appreciation).  As I have mentioned before, this author uses the Barnes Index (see our March 30, 2006 commentary for a discussion on the Barnes Index) to measure the relative valuation of equity prices to bond prices.  In our past commentaries, I discussed that we will not enter the “dangerous zone” (the zone when cash/bonds start to become attractive relative to equities) until we hit the 65 to 70 level on the Barnes Index.  As of last Friday at the close, the Barnes Index finally entered the “dangerous zone” when it registered a reading of 67.60.  Following is a chart showing the Barnes Index vs. the NYSE Composite from 1970 to the present, courtesy of Decisionpoint.com:

Of course, a huge decline isn't imminent here – especially given the fact that the market has gone on to make higher highs until the Barnes Index touch the 90 level (or even higher such as August 1987, April 1998, and January 2000) in 1981, 1983 and 1990.  But today's reading of 67.60 is consistent with the level made in the 1973 top, as well as the January 1980 top (which occurred in conjunction with the top in gold and silver prices).  One should at least expect a significant correction here – especially given the continuing rise in long bond yields and the fact that Fed still has at least one more Fed Funds rate hike to go on May 10th.

Speaking of the Federal Reserve and Ben Bernanke, I have mentioned in our prior commentaries that our new Fed Chairman has explicitly called for a policy of inflation-targeting in many of his past papers, speeches, and books on setting monetary policy.  Bernanke believes that the one and only concern of a central banker is holding down inflation – and in this sense, he is definitely more of a “hawk” than former Fed Chairman Alan Greenspan ever was.  Therefore, should Bernanke stop his rate hike campaign at 5.0% or even 5.25% sometime this summer, this will be a huge surprise – and it will totally destroy his credibility as an “inflation fighter,” given that:

1. Alan Greenspan embarked on a very aggressive hiking campaign once he took over as Chairman in June 1987 – raising the Fed Funds rate by 300 basis points over the next two years (with a mere blip during the October 1987 crash) with the Fed Funds rate peaking at nearly 10% in spring of 1989.  During the 1990s, Alan Greenspan has always ended his rate hike campaign with at least a 50 basis point hike, as opposed to the “baby steps” that Bernanke is currently taking.
   
   
2. In many ways, the 1990s economy were generally more deflationary in nature than the U.S. economy we have seen over the last few years – given the current rise in commodity prices as well as a more muted productivity gain compared to the productivity gains we saw during the 1990s.  In other words, Bernanke should now be more aggressive in fighting inflation than Greenspan ever was in the 1990s – given that Greenspan had a hugely deflationary/productivity trend on his side.
   
   
3. The 11-year high in the March Cleveland Fed median CPI reading – and further evidence that the rise in commodity prices is being passed on to U.S. consumers.  This can be witnessed in the strength of the Dow Transports – not to mention the airlines – a group which had totally lost pricing power in the wake of the September 11th terrorist attacks.  The key commodity to watch now is natural gas – as it represents 25% of American energy needs.  Should natural gas rise in the weeks ahead in the absence of a supply disruption, there is no question that inflation will again rear its ugly head.

In other words, the Fed will most probably only stop hiking after one of the following starts to fall – and given that the Dow Transports, the OIH, and crude oil have all been making all-time highs recently, this author does not see how the Fed can justify stopping at the May 10th meeting (unless one of these indexes crash before the June 28th Fed meeting):

Therefore, probability suggests that both short-term and long-term rates will continue to move higher – especially given that many bond funds are now in the midst of again betting on a normalized (steeper) yield curve.  What does that mean for equities?  Well, it will mean an ongoing lid on stock prices – and it also means that the secular decline in interest rates (which led to a secular expansion in P/E ratios) from 1980 to 2003 has definitely come to an end, suggesting that at some point, the secular bull market in equities will fully reassert itself.

As an aside, the above chart also implies that crude oil prices will probably at least make one more new high – given the continuing strength in the Dow Transports (with the airlines being the most notable) and given that confirmation in the OIH (Oil Service HOLDRS).  My guess is that oil prices won't start to correct in a big way until there is a significant economic slowdown – meaning significantly lower SUV purchases, airline travel, and significantly lower consumer spending (which will curb energy consumption in both China and India).

As for comments on other commodities, I strongly urge you to read Warren Buffett's latest take as well as Bill Miller's commentary on commodities that we posted more than a week ago.  Although this author doesn't think silver has topped out yet, it is interesting to note that Buffett has already sold the physical silver that he acquired in 1998.

Going back to Japan, readers should be reminded that liquidity in Asia (and to a lesser but significant extent, global liquidity) is still very much dependent on the Bank of Japan and its quantitative easing policy which “officially” ended a couple of months ago but which is still in the midst of wounding down.  The Bank of Japan has gone on record and stated that it is still in the process of “mopping up” excess liquidity, and that it will be finally done by the end of this month.  This has been reflected in the plunging monetary base numbers coming out of Japan – and whenever monetary base has taken a beating in Japan in the past, it has usually resulted in an underperforming Japanese market (the Nikkei) and to a lesser extent, an underperforming Asian market.  The following chart shows the year-over-year growth (as well as the second derivative) in the Japan monetary base vs. the Nikkei from January 1991 to April 2006:

Please note that current significant divergence between the year-over-year performances of the Nikkei vs. both the year-over-year and the rate of change in the Japanese monetary base in the latest month.  Given that the Bank of Japan isn't done with mopping up its excess liquidity, and given that the Nikkei has come a long way since 12 months ago (not to mention a greater-than 100% rise since April 2003), the above chart is now calling for a significant correction in the Nikkei over the next several months.  Moreover, given that Japan has also been providing liquidity to the rest of Asia (and to a lesser extent, commodities and global liquidity), the final end of the QE policy would most likely mean an underperforming Asia as well as an underperforming commodity markets over the next several months.

Let's now discuss the most recent action in the stock market.  First of all, readers should note that “the tape” is still very much split – with many large caps still underperforming while small and mid caps continue to power ahead.  In our January 19, 2006 “Brand Name” update, we had discussed that bull markets do not last long when the major brand names do not confirm – and since that time, three of the top five U.S. brand names (MSFT, IBM, and INTC) have declined further – while the other two (KO and GE) have only gotten marginally better.  At the same time, two of the fastest-growing brand names, Google and Apple, have also underperformed the market tremendously over the last six months.  This is a significant divergence – and should definitely be taken into account by our readers, even as both the Dow Industrials and the Dow Transports continue to rally to new cyclical bull market highs.  The $64-million question: Will the rallying Dow Industrials “pull” the U.S. brand names up, or will the U.S. brand names lead the broad market down?  History suggests that before any change in leadership (such as from small caps to large caps), the market has always corrected.  Will this time be different?  As can be seen in our DJIA Timing System, our answer is “no” but we are willing to change our positions should we turn out to be wrong.  Stay tuned.

Let's now take a look at the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 1, 2003 to the present:

Impressive indeed – as the Dow Industrials rallied 210 points over the last week while the Dow Transports rose a whopping 293 points (6.3%)!  Since its October 2005 low, the Dow Transports has rallied an impressive 38% - even in the face of stronger oil prices.  At some point, either the Dow Transports or oil will need to decline – and this author is betting that the Dow Transports will “blink first.”  At the same time, the Dow Utilities rose 14 points in the latest week, but note that the Dow Utilities topped out eight months ago and is many points away from the all-time bull market high of 437.63 made on October 3, 2005.  Moreover, given that bond prices have shown no signs of life even though it is in a very oversold condition, it is doubtful that the Dow Utilities could continue to build on its gains over the last several weeks.  Given the non-confirmation of the Dow Utilities and given the tightening global liquidity conditions, there is a strong chance that both the Dow Industrials and the Dow Transports will at least endure some kind of correction after the May 10th Fed meeting.

I will now end this commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  Over the last few weeks, the average of our most popular sentiment indicators has remained very steady – again, while the short-term readings of these indicators may be more on the neutral side (relative to the readings we have gotten over the last couple of years), readers should note that these readings are still pretty overbought relative to the readings since January 1997.

During the latest week, the four-week moving average of the bulls-bears% differentials of these three popular sentiment indicators declined from 23.7% to 22.1.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week (note that I have redid the scales and shortened the time period by changing the starting month from July 1987 to January 1997):

Our view on this does not change from last week: The fact that this sentiment indicator is still tilting towards the neutral side tells us that there may be more room to run on the upside – but given the weakening breadth numbers, tightening liquidity, and the overbought conditions in our other technical indicators, this author won't be willing to bet on the long side here until our sentiment indicators get significantly move oversold (for example, readings that would put us at the October 2005 levels).  In the meantime, readers should note that the sentiment indicators don't need to get overbought again before we have a market sell-off – and thus given the overbought conditions in the stock market and given declining global liquidity, readers should be very wary nonetheless of holding stocks in general here.

Conclusion: Our conclusion does not change from last week's – and that is, the probability of a significant stock market top (and a top in international equities and many commodities) continues to increase by the day – as evident by declining liquidity, historically significant divergences, as well as a “dash to trash” – a phenomenon that typically only occurs at major stock market tops.  Readers should now note that the Japanese monetary base is plunging – and this has been a very good historical leading indicator of the Japanese, Asian, as well as the commodity markets.  As for the U.S. stock market, readers should note that the major brand names are still underperforming – which should definitely not bode well for the major U.S. market indices going forward.

At this point, readers are urged to be very defensive and to be very aggressive in culling weaker-performing stocks from their portfolios.  In the short-run, this author will look to shift to a 100% short position in our DJIA Timing System, given that the market has continued to rally over the last week going into the May 10th Fed meeting.  For now, stock selection (both on the long and the short side) continues to be the key.  As for bonds, the short-term and intermediate-term trend is still down, although we will continue to keep an eye on bonds and will most likely do some kind of trade on the long side within the next several weeks (probably by the end of this month as Japan's QE policy still has not ended yet).

Signing off,

Henry K. To, CFA

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